NEW YORK (CBS.MW) -- Deflation? Possible. But v-e-r-y unlikely, given the last hundred years of financial history.

In fact - wait for it - inflation may be coming back.

We conclude this on the basis of two centuries of data on real returns to key financial assets developed by Jeremy Siegel of the University of Pennsylvania's Wharton School of Business (obtainable from his Web site http://www.jeremysiegel.com/). Siegel is the author of the classic book &quot;Stocks For the Long Run.&quot; http://www.jeremysiegel.com/book.asp

In our column on Monday, we charted the 1801-2002 total cumulative real return (that is, counting capital gains and interest or dividends, plus adjusting for inflation) for stocks, bonds, treasury bills, and cash (i.e. the purchasing power of a dollar bill under the bed - not counting any collectible value).

The main message of Monday's column: the remarkably consistent underlying growth of cumulative total return in stocks - averaging about 7 percent annually for two centuries.

Because the growth rate is so consistent, it shows on our log scale chart as a straight line slanting up -- our line is actually a regression line, derived from a statistical method of averaging Siegel's annual data points.

That is the indisputable truth at the heart of the buy-and-hold philosophy so popular in the late 1990s.

But in Wednesday's column, we zeroed in on the stock market. We found that stocks are now slightly (14.7 percent) below their long-run trend line.

So stocks are not at the extreme overvaluation of 1999, when they reached 81.3 percent above trend, at the high end of their historic range.

But stocks are nowhere near the low end of their historic range - for example, they were 40.6 percent below trend in 1974.

Obviously, it's difficult to draw short-term conclusions from these long-term numbers. But they do provide perspective. Our interpretation: the market does not have much upside energy. It still has downside potential.

Short of going down, the market could very well just stooge along sideways for several years, give or take a few thousand points. Or show mediocre gains. It's done that before - it's perfectly compatible with that 7 percent long-run real average growth rate.

Now look at Monday's chart again. Look at the total cumulative real return line for bonds and bills. Note that, unlike the line for stocks, these lines inflect somewhere around the start of the last century. The underlying growth in rates of return for bonds and stocks apparently changed. See related column.

We don't know why these inflections occurred. But we hypothesize it had something to do with the advent of the Federal Reserve system in 1913 and its subsequent impact on the monetary environment.

Another reason we hypothesize this Fed connection: look at the value of a dollar bill on Monday's chart (the drooping green line.)

The dollar bill was surprisingly stable, i.e. held its purchasing power, right through the nineteenth century - it was about as good as gold. Then it tanked in the twentieth century -- after the advent of the Federal Reserve.

Hmmm.

NOW (Ta-Ra!) look at today's chart. It zeroes in on bonds, bills and the dollar over the twentieth century.

Because the annual real total cumulative return rates have been relatively consistent in the twentieth century (1.18 percent for bonds. 0.03 percent for bills) we've been able to draw regression lines through them.

The result looks ominously like the stock total return chart in 1999. Both bonds and bills are actually above or near historic highs by the standards of the last century - 92.4 percent above trend for bonds, 32 percent above trend for bills.

This is why we are dubious about the likelihood of deflation. Deflation would drive the total cumulative real return lines for bonds and bills even higher. That's because the nominal value of bonds and bills would remain the same. But their real value would increase, as deflation increased their purchasing power. So the real cumulative total return would on bonds and bills would reach levels unprecedented since the advent of the Federal Reserve.

We're not saying it can't happen -- just that it would be a radical departure from the financial patterns that have prevailed for nearly 100 years.

Deflation seems particularly unlikely given the experience of the dollar bill's value in the twentieth century. It tanked -- so completely that even the celebrated deflation of the Great Depression itself shows as an almost undetectable twitch. (Look at 1932 - don't squint too much.)

Moral: inflation was the central reality of the twentieth century. And it continues. For deflation to occur, the cumulative value of the dollar bill would have to turn up -- something it hasn't done, decisively, for a hundred years.

Our chart shows that, throughout the twentieth century, bonds and bills have moved in very long bull and bear cycles. The current bond bull cycle began in 1980. Before that, there was a bond bear cycle that began in the 1840s.

These cycles occur because of the ebb and flow of inflation -- especially relative to interest rates. It is fact that real interest rates have been positive, i.e. nominal interest rates have exceeded inflation that have made Treasury bills such an excellent (albeit unsung) investment over the last two decades. Conversely, negative real interest rates are the only way the total cumulative return of Treasury bill can decline.

Both the bond and bill cycles, however, are now at peaks that they have found unsustainable over the last century. If and when bonds and bills reverse, it will be because real interest rates are falling. In other words, because inflation has returned.

Overall, our three charts suggest we are entering an era when all financial assets will be under pressure -- stocks, bonds, and bills.

This sounds alarming. But it's not new. It's merely what happened in the 1970s. The combination of a weak economy and inflation was called &quot;stagflation.&quot; The ultimate 1970s antidotes: stockpicking rather than buying the market, real estate, tangible assets, gold.

And Jeremy Siegel? Naturally, as befitting an academic, he's more cautious. And over the years, we've found he'd more cheerful.

In the short run, Siegel expects a resumption of 5 percent to 7 percent real growth in the stock market, simply because his broad measure of stocks is back down to the middle of its range and 5 percent to 7 percent is the average growth rate.

But he does think bonds are vulnerable -- and he agrees with us that deflation (probably) ain't going to happen.

Editor's note: The April edition of the Hulbert Financial Digest is now available by either e-mail or regular mail. Highlights this month include:

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